RGE’s Nowakowski and Das Debate: Why Not Make the EFSF a Hedge Fund?

Below is an exchange that took place between RGE’s David Nowakowski, director of fixed income strategy, and Arnab Das, managing director of market research and strategy. This is just one of the many discussions that takes place daily at Roubini Global Economics.

David Nowakowski: In October, the EU revealed two convoluted plans to leverage the European Financial Stability Facility (EFSF), which will probably never lift-off, and if it does, will greatly contribute to longer-term financial instability – since it will fail to be powerful enough to move markets itself or add enough moral hazard to get markets to push PIIGS yields down to low levels.

The October announcement mentioned that the two measures chosen were the ones deemed the best, but did not detail other options considered. In fact, the actual amount of risk increased by the purported 4-5 x leverage is modest, and conditional on a default event occurring. True leverage – borrowing against capital, and taking 400-500% more exposure – was avoided. However, this can easily be done under the existing structure, as I understand it.

First, the EFSF should abandon its current m.o. of loans to countries when they’ve already lost confidence. Just like the TARP was eventually used for a purpose that was buried in the fine print, the EFSF should turn itself into a giant hedge fund, using powers it has that most of its makers probably didn’t intend to be used. Forget about getting a banking license and dealing with the closed-minded, high-handed ECB. The EFSF already has the tools it needs, according to official “EFSF FAQ” documents:

It can issue bills for short-term funding, to access liquidity and funds separate from country programs (see note B2 in the FAQ).

It can use repos with commercial banks, (see D14), which are instructed to attach a zero-risk to their credit exposure with the EFSF, so credit limits should be very large and costs/charges small.

With these tools, the EFSF can leverage five, ten, a hundred times if it wanted to, though margin requirements (now over 10% for some Italian bonds), would limit the leverage to 8-9 times if you continually buy, repo, repeat and sum up the resulting geometric series. The ECB would end up holding the bag at the end of the day, because both the EFSF bills and the repos of Spanish and Italian debt that the EFSF did with various banks would in turn be repoed again with the ECB. I do not see how the ECB can refuse to provide liquidity for such eligible collateral. The only thing missing is the willpower – they need to hire Jon Corzine (who was very good at buying PIIGS debt and leveraging to the hilt), or perhaps Joseph Yam, who took on the markets and won when he headed the HKMA in 1998.

Is this a good strategy? I don’t know, I remain very skeptical that the euro or any pegged system is the right monetary arrangement for Europe. There is still a great need for reforms, adjustment in competitiveness, the core to abandon its suicidal austerity, etc. But this is the way that the EZ and its members can go “All-In”. At worst, it will buy them a lot of time and take risk out of the markets and in particular the banking system. At the same time, behind the scenes they should lay out an exit strategy, in case the EFSF-HF fails, so an orderly way out can be attempted rather than an uncontrolled break-up, which is where we’re still heading.

Arnab Das: A hedge fund would have to borrow from someone, somewhere. Calling it a hedge fund without a banking license would leave it with the same issue of circularity: sovereigns who’ve already or are in the process of being at risk of losing market access are back stopping themselves with no real money. They are at the mercy of the market.

The HK analogy IMHO is inaccurate. The HKMA intervened in the equity market with the fiscal reserve built up over time by the HK SAR from budget surpluses and I think borrowing in better times. It was part of the design of the currency board system that it would have very strong fiscal accounts and buffers to help sustain it against speculative attacks. Without having to borrow in bad times or violate the rules of the currency board in order to sustain it.

This design feature was used if modified for the Bulgarian currency board system, with massive excess reserves (fiscally funded too).

The EZ fixed exchange rate system has no such anchor or buffer, so suffers the slings and arrows of outrageous fortune often, now that times are bad and people realize the emperor is naked as the tide of EZ liquidity recedes.

IMHO, the moniker or structure attached to the EFSF is a red herring. The EZ needs to band together rather than band aid. There’s some chance that a joint/several liability approach to the EFSF might work, but that is very unlikely as Germany has made clear that a liability union will come only after a political and fiscal union–it will resist putting its credibility on the line unless it is running the show…understandably.

Separately, this normative approach to the crisis and its management is valuable for benchmarking what will actually happen.

DN: The EFSF-HF would borrow, just like a HF/SIV/Conduit. The whole structure would then be vulnerable to ST funding.

It is “real money”, and commits German and Dutch and French credit to the cause of “saving the euro”.

I don’t think this idea is very smart at all, and certainly am not saying it solves anything. My point is, this is the “go for broke” option, with going broke a possibility if whatever time it buys isn’t used well. Though, I also don’t think it has a serious chance of coming to pass.

AD: Agreed it would probably not work and certainly would not solve anything!

But if the putative EFSF, itself a CDO in effect, is having trouble leveraging itself up as a CDO^2 and is having trouble borrowing on the back of the existing guarantees, then why would calling it an HF make it easier to borrow? The central issue is that Germany is the only sizeable solid AAA country left, Holland is redoubtable but tiny and has some large bank balance sheets it might have to defend in extremis. France does too, and it is not a solid but a borderline AAA (wrong side of the tracks actually).

These SIVs, not to say sieves, CDOs, HFs and banks had access to debt when times were good and credit easy. Now money is free but credit is tight… and a HF is just a type of bank, borrowing short/liquid to lend long/illiquid… but doing so without a banking license is a riskier proposition for its creditors…